New Laws Take Guesswork Out of Investment Tax Liability

Until recently, the tax man rarely held you accountable for how much you profited — or lost — when you sold stocks or mutual funds.

Instead, reporting those numbers on your tax return was generally based on the honor system: You reported how much you bought the stock for, and if you lost track or couldn’t remember, you made your best guess. The tax collectors didn’t have an automated way of checking your calculations.

Those days are over, at least in part. For the second consecutive tax season, a new law requires your investment brokerage firm to report to the I.R.S. the price you paid for certain taxable investments, known as your cost basis, a figure that also takes into account items like reinvested dividends, stock splits and company mergers. With your cost basis in hand, you can then figure out how much you’ve gained or lost when you sold the investment, which is then reported on the Schedule D tax form.

“I considered the Schedule D as the last bastion of the Honest John system,” said Nico Willis, chief executive of NetWorth Services, a company based in Phoenix, that calculates cost basis for investors. “The spotlight is now on, and as a result, that is making things a lot more complicated because you just can’t guess anymore.”

The new reporting rules, signed into law as part of the big bailout legislation in 2008, are being phased in over a few years and don’t necessarily apply to all of your taxable holdings: banks and brokers were required to begin tracking and reporting the cost basis of stocks in taxable accounts bought in 2011 or later. Mutual funds, dividend-reinvestment plans and certain exchange-traded funds purchased beginning in 2012 are subject to the new rules. That means this is the first tax year these funds will be reported to the I.R.S. Reporting for bonds and option contracts doesn’t begin until next year.

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Robert Neubecker

Technically, the changes should eventually make it easier to figure out capital gains or losses. But for now, you’re more likely to be befuddled by the fact that the sale of some of your taxable investments is covered, while the sale of others is not, though all of this is broken down on your 1099-B tax form prepared by your bank or brokerage firm. Given the added complexity, tax experts suggest going over everything carefully to avoid setting off an inquiry from the I.R.S.

“If you bought a mutual fund 10 years ago that you are still holding onto and reinvesting the dividends, you will have a combination of covered and noncovered securities,” said Joel M. Dickson, a tax specialist at Vanguard. “It can be a little confusing. And the onus is still on the investor to report their cost basis, regardless of whether it is covered or not covered” by the new rules.

The new rules will also require you to pay closer attention to which specific shares you want to sell. Before, most investors just waited until tax season to select which lots, or groups of shares purchased in the same transaction, they sold first. (Even though, technically, they were supposed to decide at the time of the sale.) And naturally they would pick the ones that would be best for their tax situation. Now, you need to decide how you want to calculate your cost basis within three days of the trade settling, tax experts said, and brokerage firms including Vanguard and Charles Schwab said they would lay out the choices at the point of sale.

The method you choose can have a pretty drastic impact on your tax bill, at least in some cases. Let’s say you bought $1,000 of Bank of America stock, or about 62 shares, back in August 1980 (a predecessor to today’s company was then known as NCNB Corporation). And assume you reinvested all dividends back into the same stock. Now, almost 33 years later, your stock holdings are worth about $19,000. If you sold $10,000 of the stock earlier this week, or about 830 shares, you would have the option of generating a giant gain, or a big loss, all depending on what method you use. For instance, if you sold the oldest shares first, you would log a capital gain of more than $7,100. But if you sold the newest shares first, you could post a loss of more than $14,000, according to calculations by NetBasis, the unit of NetWorth Services that provides cost basis calculations for investors.

If you don’t pick a specific method, most brokerage firms will revert to their default, whereby they sell your oldest shares first, known as first in first out, or FIFO. (This applies to stocks and exchange-traded funds. For mutual funds, the default method is a bit different; they use the average cost of the shares held.)

“When people buy stock over time, FIFO may not be the best option,” said Thomas B. Cooke, a tax and business law professor at Georgetown University’s McDonough School of Business. “That makes it very incumbent on investors when they get their confirmation statement to make sure the right stock was sold.”

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Nico Willis, chief executive of NetWorth Services, said the new rules made paying taxes more complicated.Credit
Joshua Lott for The New York Times

You can choose from several different methods: You can sell the newest lots first, for instance, or you can unload the highest- or lowest-cost shares first. Or, your brokerage firm may have a tool to help you decide. At Schwab, for instance, a tax lot optimizer will choose the lots that let you take losses first. (Of course, if you are selling all of your stock, choosing a method is a moot point.)

Michael Kitces, research director at Pinnacle Advisory Group Inc. in Columbia, Md., said that most investors would probably prefer to either sell the highest- or lowest-cost investments first, depending on their goals. The highest cost method is a classic attempt to minimize your tax bill because you are selling positions with the biggest losses first, then shares with smaller losses, then the smallest gains, and lastly the biggest gains, he said.

Conversely, if you sell the shares with the lowest cost basis first, he said you were going to take the biggest gains first, then smaller gains, then the smallest losses, and then the biggest losses. That method might seem counterintuitive, but would make sense for investors expecting their capital gains tax rate to rise, he added, because they might fall into a higher tax bracket in the future. (He points out that married couples with $72,500 of income or less, after deductions, are eligible for the zero percent capital gains rate, so harvesting gains is a better option.)

Finally, there’s another wrinkle to the new rules: brokers are also required to report what’s known as wash sales on securities covered by the new regulations. That is when you sell a security at a loss and buy substantially the same investment within 30 days before or after the initial sale. (The firms will only be required to report wash sales within the same account, even though they are not allowed across all accounts. If it occurs elsewhere, it is up to you to report.) It’s easy to inadvertently run afoul of these rules if you’re automatically putting money into similar investments in other accounts, or you’re reinvesting dividends. And if you do, that means you won’t be able to take the deduction, experts said, at least for now.

Given all of the changes and ample room for confusion, many of the brokerages now have areas dedicated to cost basis reporting on their Web sites, and some provide detailed instructions on how to change your cost basis method for subsequent sales (though, if you already sold mutual funds using the average cost method, you must stick with that strategy for remaining shares, Mr. Kitces said. But you could use a different method for new purchases). The good news is that if you decide to change brokers, they are now required to to send your cost basis data to the new firm within 13 days, according to Schwab, so long as they have that information. And many firms may already keep track of your basis, even if they are not required to send it to the I.R.S.

Meanwhile, as a result of the new rules, the I.R.S. updated the relevant tax forms and added a new one. The 1099-B, the tax form sent by your broker that summarizes the proceeds from the sale of your investments, will now include your cost basis, sale price and the date you acquired the shares. Make sure that there are no errors and that the information matches your records. You will still need to transfer that information to the Schedule D, a form you submit with your overall federal tax return, but now you will also have to fill out a new 8949 form, where you must list individual transactions (and you’ll need to fill out a separate 8949 for investments that are covered by the new rules, and another one for investments that are not, according to Mr. Kitces). You can expect to hear from the I.R.S., he said, if your figures don’t match its records.

“Before the new rule, the I.R.S. had no clue what my basis was,” Professor Cooke said. “It had no idea what I paid for it and relied on the investor to be honest. Now, there is no wiggle room.”

Correction: March 19, 2013

The Your Money column on Saturday, about the automating of calculations on capital gains and losses from stock sales, misstated the time elapsed if one had bought shares of bank stock in August 1980 and had reinvested the dividends since then. It is almost 33 years, not 13 years. The column also referred incorrectly to a predecessor of the current Bank of America. In 1980, it was known as NCNB Corporation — not as NationsBank, a name it did not adopt until 1991.

A version of this article appears in print on March 16, 2013, on Page B1 of the New York edition with the headline: New Laws Take Guesswork Out of Investment Tax Liability. Order Reprints|Today's Paper|Subscribe